- 27 -
2. She subtracted an amount equal to 5 percent of
Demco’s working capital in 1991, because she assumed working
capital would grow from that level at a 5-percent rate.
3. She added an amount equal to 5 percent of Demco’s
indebtedness in 1991, because she assumed debt would
increase from that amount at a 5-percent rate.
4. She subtracted an amount equal to the excess of
Demco’s average capital expenditures for 1987-91 over its
average depreciation and amortization for that period.
5. She increased the overall result by 5 percent,
because she assumed Demco would grow 5 percent from 1991 to
1992.
On the basis of all these calculations and assumptions, Ms.
Walker determined that Demco’s normalized free cash-flow for 1992
would be $720,317.
19(...continued)
Small to Medium-Sized Businesses, at 198-199 (1998). By
contrast, the argument against tax-effecting stresses that
although an S corporation’s stockholders are subject to tax on
the corporation’s income, they are generally not subject to a
second level of tax when that income is distributed to them.
This could make an S corporation at least somewhat more valuable
than an equivalent C corporation. However, tax-effecting an S
corporation’s income, and then determining the value of that
income by reference to the rates of return on taxable
investments, means that an appraisal will give no value to S
corporation status.
In her revised report, Ms. Walker computed the present value
of Demco’s tax-effected cash-flow using a capitalization rate
determined by reference to the market rates of return on Treasury
securities and common stocks. See infra pp. 28-29. The interest
and dividends on such investments are fully taxable to their
holders. Because this methodology attributes no value to Demco’s
S corporation status, we believe it is likely to result in an
undervaluation of Demco’s stock. See Gross v. Commissioner, T.C.
Memo. 1999-254.
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